THE EXPECTATION RATIO REMAINS CONSTRUCTIVE DESPITE RECENT DECLINE
What a curious market we are confronted with. It’s now quite clear that the rally is living on the liquidity based fuel from the Fed and the declining dollar. In terms of valuations, the market appears fully valued if not overvalued. It’s also quite clear, based on GDP, retail sales and the ISM data, that the economy is rebounding off the deep trough of Q1 2009 in what has to be one of the greatest mean reversions of all time. From a technical perspective the market is in a robust uptrend. Most importantly, we are in the midst of an expectations & earnings recovery.
So, while the rally appears to be ahead of the fundamentals, a confluence of positive momentum, upside data surprises and very negative earnings expectations continue to provide support to the market. The sum of these sentiments and fundamental aspects have been most evident in our expectation ratio. While the earnings rebound has been less than robust, expectations have lagged substantially. I can’t recall a period where analysts were so wrong. As you can see in the ratio (chart below), the steep upward slope is consistent with an environment in which expectations are misaligned with reality. This gives companies an almost unprecedented ability to under promise and over deliver.
Ever since our March 8th bottom call, I have maintained that the market could not be shorted. This was almost entirely due to the surging expectation ratio. Earnings and expectations drive stocks. With a rebound in earnings and an analyst community that saw no such thing it was clear to us that you couldn’t bet against the earnings trend (regardless of how weak the real underlying fundamentals of the economy were and are). With over 70% of companies outperforming analyst expectations it is practically impossible for the ratio to accelerate much higher. The analysts simply can’t be more wrong (see below). With that said, the current reading of 1.75 on the ER is still extremely high and represents an environment where analysts still have a great deal of ground to make up. As we said many weeks ago when we sold into the current rally at S&P 1,100 we expected a substantial number of upgrades and price target increases to support the market. This trend, though likely to improve as analysts increase expectations, is still firmly intact and continues to lead me to believe that the market cannot be shorted.
So where are we now? My macro view is still that of the secular deleveraging bear market. Much like Japan, we cannot create the foundation for a new secular bull without dealing with the underlying problem of debt. On the bright side, we are 10 years into our bear market. On the downside, we seem to be making all the same mistakes that Japan made as opposed to actually confronting and destroying those problems. This creates further risk of a long and drawn out recovery as deleveraging continues to weigh on consumers and the government.
In terms of my micro outlook I continue to maintain the position that the fundamentals no longer support the v-shaped recovery that equities are pricing into the market. I would not be shocked if the market rallied into year-end as investors chase performance, but the uncertainty regarding 2010 appears staggering in my opinion. Like a chess player thinking many moves ahead, I believe investors are wise to get ahead of their opponents. The smart money will begin focusing on 2010 soon and is likely to pare back risk as the uncertainties remain numerous.
As earnings officially end this week the fuel for the rally is coming to an end. The endless upgrades and earnings beats are coming to an end and that means investors will begin to focus on the real economy again. With the dollar near its lows and the market extended I think the potential for a counter-trend dollar rally and commodity decline adds substantial risk to the market in the near-term. I will maintain my cautious and patient approach to this market until a more attractive opportunity presents itself. Despite the underlying strength in earnings, the risks in this market remain substantial.
Cullen Roche
Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.
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20 Comments
Again you say the market cannot be shorted
your number 1 indicator tells you to stay long
yet you are essentially sidelined for about 4? 6? weeks?
I remain boggled by this dichotomy… you can’t short a market – so by implication that would offer a “long bias” but you won’t go long. Unless the belief is sideways for months on end. Your top indicator, which you say has not failed you also says to go long, yet you abandonded it a month or so ago.
When these discrepencies are noted you start to get ruffled and say one should read your 8 month history of calls, etc etc. A model portfolio will be up “shortly”, and then 4 weeks later the same comments are offered.
I first visited the site about 4-5 months ago, and readers asked for a model portfolio that would clearly explain your views and show your performance. You state it’s in process. Will we see it in 2009 ? How much longer is a process that I assume would take 20 minutes a week? An excel spreadsheet would seem sufficient.
The market has moved higher by less than 1% since I sold a month ago and you’re somehow trying to imply that I am wrong for being sidelined and lacking conviction.
Why readers feel like they always need to be doing something, always fully invested, is beyond me….
For me it was experience. It took me a few years before I realized that there are three ways to play the market: long, short, and do nothing if the risk/reward is not there either way.
The other answer to any criticism always is “risk adjusted” returns are superior but again, without a model it is impossible to see that. The market is up 60%+ from the lows of March 2009; what would your returns be in your typical client account?
Because I assume risk adjusted 15% is better in your world than risk “full” 70%?
These are rhetorical questions, I’ve seen them raised many times – until that long awaited model portfolio is up, it will just be rehash. I’ll wait patiently for this long awaited risk averse model that still out performs in almost any market.
I don’t write this site because I expect readers to follow my advice. In fact, I think you are incredibly ignorant to follow the advice of a total stranger who you know little to nothing about. The site is a compilation of a diverse set of thoughts and opinions (many of which are my own). It is on the reader to decipher those thoughts and implement them as they please. I try my best to nudge the reader in a direction or provide some actionable ideas, but the ultimate responsibility is on the reader to make a market decision.
I am not your financial advisor and I am not here to provide guidance. I am sincerely happy to help and teach however I can. I like to think I am helping people by running the site. I try to be honest about my market calls and point out negative AND positive calls where they occur just like I point out a lot of investor’s good calls and bad calls when I post stories about them.
As for a model portfolio, it takes months to build up a track record of risk adjusted returns. My model portfolio is only about two months old and the site is less than a year old (and only became popular about 5 or 6 months go). I could post my model portfolio and ramble on about outperformance, but given the short lifespan that would defeat the purpose. In addition, global macro only accounts for about a 3rd of my real-life portfolio so it’s important to me not to misrepresent my knowledge of the market via a “model portfolio” if that portfolio does not accurately portray my talents (what little there may be). Unfortunately, my other strategies will never be disclosed here.
I don’t know what else to tell you. My calls are pretty cut and dry generally and easy to follow. Decipher them however you please….I am all for criticism….No one is perfect. Especially not yours truly.
And trust me, I wish I had more conviction now regarding market direction. Sitting mostly in cash is very boring, but this isn’t a game. It’s not “fast money” or “mad money”. Investing is “boring money” and that’s how it should be. Patience is difficult to acquire in this business, but it is the ultimate trait in any truly great investor.
I for one love this site. If you want to be bullish and read bullish articles all day long go to CNBC. If you want to be bearish and read about doom and gloom then go to ZeroHege. But if you want to see opinions on both sides, then this site it the place to visit. Keep it up TPC. I for one read and read and read, then after doing that, I read some more. Only then do I start to think about how I’m going to use that information to position myself in the market. What you do TPC is your business. I don’t see the need for you to post any results. After all, you’re not managing our money, just offering your opinion, as well as others. And I might add, it’s all for free. Well done to you, from someone who is more concerned about getting good insight on macro themes than seeing your record of picking tops and bottoms on the Dow.
Keep on working this way TPC! I don’t really care about the model portfolio. I care about having a top quality website that gives me very good info to build my own strategy on mkts. Thank you, you’re doing a wonderful job!
TPC,
Maybe you could publish (links to) more information on managing risk from various respected sources.
I also would like to know your definition of a risk adjusted return.
I for one am more comfortable with managing risk via asset allocation, but almost never going to zero or putting all my eggs in one basket. Going to 100% cash is essentially putting all your eggs in one basket (unless diversified among currencies).
I can’t predict the future. I can only make an educated guess as to what might happen and then react to it when it happens.
People think you have all the answers because you seem to have an uncommon sense of the markets. I speak for everyone when I say that I am thankful for your hard work and would appreciate more disclosure on your actual positions. Consider it a compliment rather than an insult.
TPC,
I’ve said it before and I’ll say it again, this site is great!
I come here for the even presentation of news and the PRAGMATIC approach to investing. Thanks!
I know you are not running the site for me so please take this with a grain of salt.
Someone who says they are building a track record off line, to present to readers after the fact is going to set themselves up for a lot of criticism.
If you have the model up and running – which it sounds like you have for 1-2 months, it should be online so we can see how it reacts in the real world. It should not be presented next March when it has 6 months under its belt and you can tout “it did this the past 6 months”.
It’s not about the lifespan… it can be 1 day old but from that point forward we can see how it does.
James lower in the page made a comment that is accurate. You make calls, but don’t seem to make portfolio moves to take advantage of those calls. Some of the time. Once more, in March 2010 you can tell us you were out of the market and between mid Oct and mid November the market barely moved. But without the data presented between mid Oct and mid Nov it seems less useful.
Once more, the website is not run for me, it is your show – but seeing something live week to week is going to be a lot more meaningful than a back tested product that you say was live during the past 6 months. It is very easy to back test anything into success.
Seems to me that there is a slight impertinence from L2 (although in general I hold that bloggers should be held to task). From all that I have read you do not seek to offer specific investment advice or bragging rights but simply to offer a forum that presents your well-informed thoughts and offers a broad forum for discussion. Keep it up.
Franky, I wish I’d listened to you a month ago and done nothing. I would have avoided lots of pain. Sometimes- “Do nothing, I have no conviction one way or another” is the best advice.
Ignore the criticism.
Damn it TPC – I want my money back. Oh wait, the site is free…
(keep up the great work)
TPC the markets haven’t moved much from a point A to point B area since you sold but it has moved almost 9% down in late October and 10-11% back up to now. I’ve seen your calls, which have been good, but I have never seen you say you traded any of those calls. Sometimes people make calls but don’t trade and maybe you are just trying to keep face when you say you have risk adjusted returns. Like I said before you seem to have a good feel for the markets but don’t seem to trade much on those feelings. With that being said, I come on here for the different opinion pieces you post from other people so I don’t really care if you’re trading or not…
TPC,
I appreciate your site more than you know. You present bull/bear articles daily for all readers to make their own decisions and take proper positions. On the relatively rare occasion when you post about your macro and micro outlook via, for example, the Expectation Ratio, I relish seeing the market from your perspective. Your thoughts are very informative and reasonable indeed. So far, you have been right more often than wrong. I wish I had found your site before March bottom.
One question: what level does the Expectation Ratio have to fall to in order for you to take a short position confidently?
Thanks Gray.
The downward momentum in the ER concerns me, but it is coming from such a high level that I am not overly concerned about it. If we were to approach 1 I would begin to get very concerned about the market again. I see the ER flattening out and the market becoming very boring for the next few years as earnings are relatively sluggish and expectations catch up to reality….
TPC: “I like to think I am helping people by running the site.” Works for me
FWIW, I was very intrigued by,
“global macro only accounts for about a 3rd of my real-life portfolio… that portfolio does not accurately portray my talents (what little there may be). Unfortunately, my other strategies will never be disclosed here.”
Presuming to read between the lines, I suspect you focus on the debt side of the business? Obviously, there has been tremendous volatility in that space over the last year, or even two. Equities are so well-covered that it seems like more info on how a pro trades bonds/debt might be verrrry educational.
Just my two cents. Keep up the good work.